Transcript Income Taxes - Lanzhou University of Technology

Part Six: Accounting for
Enterprise Income Taxes
Key Issues
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Book (financial statement) vs. taxable income
Permanent differences
Effective vs. statutory tax rates
Temporary (timing) differences
Deferred taxes: Assets, Liabilities, Expense
Possible cases and examples
Components of income tax expense (current vs deferred)
Tax journal entries
Originating vs reversing differences
Asset, Liability (B/S) method vs I/S method
NOL carryback and carryforward
Deferred tax asset valuation allowance
Footnote disclosures:
Paul Zarowin
2
3 Parts of Tax Disclosure
1.
Current vs. deferred expense
2.
Reconciliation between statuary vs. effective tax
rates
3.
Changes in Deferred Tax (DT) assets/liabilities
and/or components of DT expense.
Paul Zarowin
3
Key Identity
Pre-tax book (accounting) income
±
Permanent differences
±
Temporary differences
=
pre-tax taxable income
Paul Zarowin
4
Permanent Differences
Definition:
Items of revenue or expense that are in book (or
taxable) income of a period, but never part of
taxable (or book) income.
2 types:
1. non-taxable revenues
2.
(ex. interest income on
municipal bonds)
non-deductible expenses (ex. GW amortization)
Paul Zarowin
5
Importance of Permanent Differences:
Effective vs. Statutory Tax Rate
def: effective tax rate (ETR) =
tax expense
pre-tax (book) income
def: statutory tax rate (STR) = rate set by government



permanent diffs cause ETR  STR
non-taxable revenues lower the ETR
non-deductible expenses raise the ETR
ex. E13-7, E13-8 (Kent)
Paul Zarowin
6
Temporary (Timing) Differences
Temp. diff. cause deferred tax assets, liabilities, expense
Definitions:
 Temp diff: item of revenue or expense that are part of book and
taxable income, in different periods

Deferred tax asset: future tax deductible due to current timing

Deferred tax liability: future tax payable due to current timing
difference
difference
Q: What is sum of temporary differences over firm’s life?
Paul Zarowin
7
4 Possible Types of Timing Differences
Revenues
Expenses
recognize for
books before
taxes
1. Accrued (asset)
revenue
3. Accrued (liab)
expense
recognize for
taxes before
books
2. Deferred
(unearned)
revenue
4. Deferred (prepaid)
expense
Paul Zarowin
8
Ex. 1. accrued asset, receivable
Books = accrual accounting
period 1:
period 2:
DR
A/R 100
CR
Rev 100
DR
Cash 100
CR
A/R 100
Taxes = cash accounting
DR
DR
Cash 100
CR
N/A
CR
Rev 100
Note: total revenue is the same, just timing differs
Paul Zarowin
9
Ex. 2. unearned revenue
Books = accrual accounting
period 1:
DR
Cash 100
CR
Liab 100
period 2:
DR
Liab 100
CR
Rev 100
Taxes = cash accounting
DR
Cash 100
DR
CR
Rev 100
CR
N/A
Note: total revenue is the same, just timing differs
Paul Zarowin
10
Ex. 3. accrued liability, payable
Books = accrual accounting
period 1:
period 2:
Taxes = cash accounting
DR
Exp 100
CR
Liab 100
DR
DR
Liab 100
CR
Cash 100
DR
Exp 100
CR
N/A
CR
Cash 100
Note: total expense is the same, just timing differs
Paul Zarowin
11
Ex. 4. prepaid expense
Books = accrual accounting
Taxes = cash accounting
period 1:
DR
Asset 100
CR
Cash 100
DR
Exp 100
CR
Cash 100
period 2:
DR
Exp 100
CR
Asset 100
DR
CR
N/A
Note: total expense is the same, just timing differs
Paul Zarowin
12
Timing Differences:
Relation to Deferred Tax Assets, Liab.
Revenues
Expenses
recognize for
books before
taxes
1. Deferred tax
liability
3. Deferred tax asset
recognize for
taxes before
books
2. Deferred tax
asset
4. Deferred tax
liability
Paul Zarowin
13
Components of Tax Expense and Tax JE
Components of tax expense: 1. current (pay now); and
2. deferred (paid before or after)
1.
DR current tax expensea
CR
Cash or taxes payable
Assumes positive
taxable income
a) Current tax expense = taxable inc.*current statutory tax rate
2.
DR deferred tax expenseb
CR
Deferred tax asset/liability
b) Deferred tax expense =
net  in deferred tax asset/liability
Paul Zarowin
can DR or CR
deferred tax
expense, depending
on net  deferred
tax asset/liability
14
Components of Tax Expense (cont’d)
Alternatively,
3. DR
total tax expensec
CR
Deferred tax asset/liability
CR
Cash
c) Total tax expense = current + deferred
Paul Zarowin
15
Deferred Tax Accounting =
Inter-period Tax Allocation
Total income tax expense =
Current (paid now)
+ Deferred (paid both before or after)
Paul Zarowin
16
Originating vs. Reversing Timing Diff.


Originating differences create deferred tax assets
(DR); and liabilities (CR)
Reversing differences reduce deferred tax assets (CR)
and liabilities (DR)
Paul Zarowin
17
Examples of Deferred Tax Assets/Liab
1. Installment sale; revenue is recognized up front
for financial reporting, but is recognized for tax
purposes later, when cash is received each period.
2. Prepayment; revenue is recognized for tax
purposes up front as cash is received , while accrual
accounting delays revenue recognition until revenue
is earned later.
3. Bad debts expense. The allowance method for
books recognizes the expense in the period of sale
by the adjusting entry (matching principle), while
the direct write-off method recognizes the expense
in a later period, when the receivable is actually
written off.
Paul Zarowin
18
Examples of Deferred Tax Assets/ Liab (cont’d)
4.

depreciation expense; firms use an accelerated
method for taxes and SL for books. This
combination recognizes some depreciation for taxes
first and for books later.
RCJ give additional examples of revenues and
expenses that produce deferred tax assets and
liabilities in Exhibit 13.1, Pg. 689-90.
Paul Zarowin
19
Calculation of Deferred Tax Expense,
Asset, Liability: B/S Method
1.
2.
deferred tax asset/liability = cumulative timing difference * STR
deferred tax expense = net  in deferred tax asset/liability
B/S method (also called asset/liability method)

use STR expected to be in effect when timing difference reverses

so, if STR changes, calculate deferred tax asset/liability as per
(2), and calculate deferred tax expense =  deferred tax
asset/liability
I/S method

for constant STR only,
deferred tax expense = current year’s timing difference * STR

B/S method is or constant or changing STR
Paul Zarowin
20
Deferred Tax Asset, Liability and Expense
Depend on Tax Rate
Key point:
Deferred tax asset, deferred tax liability and deferred
tax expense depend on the tax rate.
Paul Zarowin
21
Intuition


Deferred tax asset =
$ amount of future tax deduction (or tax saving)=
$ timing difference * STR
Deferred tax liability =
$ amount of future tax payable =
$ timing difference * STR
Paul Zarowin
22
Net Operating Loss (NOL)
NOL = negative taxable income

Book income may be either positive or negative
NOL can be carried back or forward
NOL carryback:
Get a refund of past taxes paid:
DR cash or tax refund receivable
CR
(current) income tax expense
 The maximum carryback period is 2 years (offset the earlier
year first, as in FIFO)
Paul Zarowin
23
Net Operating Loss (cont’d)
NOL carryforward:
Offset future income (also FIFO), reducing future taxes
payable:
DR deferred tax asset
CR
(deferred) income tax expense
This is another reason for deferred tax asset in addition to
timing differences.

A firm can carryforward an NOL for up to 20 years.
Paul Zarowin
24
Incentives for Carryback vs. Carryforward
1. Can’t carryback because of 2 years of
losses
2. Time value of money: get the cash
ASAP  carryback
3. If tax rates are expected to rise, a
dollar of deduction will be worth more
 carryforward
Paul Zarowin
25
Deferred Tax Asset Valuation Allowance
Contra-asset account (CR balance on the B/S ; eg, acc’d
depreciation or AUA) that reduces the deferred tax asset to
its expected realizable value
1.
2.



Record the deferred tax asset in the usual way (as if there
were no valuation allowance)
Make an additional entry:
DR
(deferred) income tax expense
CR
deferred tax asset valuation allowance
increasing (decreasing) the allowance increases (decreases)
deferred income tax expense
allowance’s existence and magnitude reveals management’s
expectation of future earnings.
management can use changes in the allowance to manipulate
NI, by affecting income tax expense.
Paul Zarowin
26
Financial Statement Disclosures
I/S : total income tax expense
B/S: net current and net non-current deferred tax asset or
liability
Footnote disclosure:
1. Current and deferred components of total income tax
expense (from Income From Continuing Operations, because the
below the line components are shown net of tax).
2. Reconciliation between the federal statutory and
effective tax rates (in $ and/or %).
C13-1, 2, 3, 5, 6
Paul Zarowin
27
Financial Statement Disclosures (cont’d)
3a. components of deferred tax assets and liabilities
and/or
3b. Components of deferred tax expense
(e.g., revenue and expense items that cause the
deferred tax expense, assets, liabilities, such as
depreciation, bad debts, installment sales, etc.)
Paul Zarowin
28